Over The Rainbow

Bill Ehrman

2 Oct 2017

Week after week we state that a successful investor must look forward through the windshield rather than back in the rear-view mirror. I came back to manage hedge funds in 2013 when the asset class was under tremendous pressure for underperforming for many years to prove that it was not the style of investing that was wrong but the inability of most managers to really synthesize the global financial, economic and political environment down to making profitable investment decisions.

Our views are documented back to February 2013 when we started expressing our global investment outlook. Paix et Prospérité has outperformed all indices by a tremendous amount running circles around the average hedge fund since we returned to the business after a successful 35-year run being Co-CIO of Century Capital with Byron Wien then the Quantum Fund and finally EGS, our own firm.

We have successfully run against the grain many times over the years and even more recently have stated that the path of least resistance was up while virtually all of the experts were calling for a top or at least a major correction. The past is NOT prologue for the future as change is everywhere for a multitude of reasons (such as the disruptors). But a successful investor needs patience and is able to look over the rainbow or into the valley, as change does not occur overnight.

Let’s take a look at what occurred last week that supports or detracts from our positive view of the financial markets: global economic growth is accelerating; inflation and interest rates remain low but the yield curve will steepen, earnings are rising, the dollar is bottoming after a large decline since winter; and Trump’s odds for passing parts of his pro-growth, pro-business agenda has risen.

U.S. economic statistics will be influenced by both hurricanes for the next year or so with most of the hit in the front months followed by benefits to growth thereafter. The latest forecast by the Atlanta Fed is that third-quarter growth will be about 2.3% down from an upward revised second-quarter growth of 3.1%. Various stats reported for the week included: PCE rose 0.1% in August while personal income was up 0.2%; U.S. families’ wealth and income hit new highs; housing inventory declined 6.5% from a year ago creating shortages and higher prices which hit a record in September; the Chicago business index hit a new high of 65.2 and consumer sentiment was 95.1, back to levels reached a year ago.

Trump’s team finally proposed its tax reform bill: the corporate tax rate would fall to 20% from 35% currently with a 5-year write off for capital investment; and individual tax rates would be set at 12%, 25% and 35% with an option for a fourth higher tax rate for the wealthiest Americans. The standard deduction would be doubled while the personal exemption would be eliminated. There is much more here – like a tax holiday for repatriation of foreign cash and no longer deducting state and local taxes. But all of this will be altered in a final bill, so why even discuss the particulars now? The bottom line is that we do expect some tax legislation to pass lowering both corporate and individual taxes which will be beneficial to longterm growth and our global competitive position. The Senate released the text of a fiscal 2018 Bridge Resolution on Friday, which will most likely lead to a vote on the tax proposals without the Democrats. We expect a huge infrastructure program to follow passage of tax reform along with continued deregulation.

Economic data points continue surprisingly good in the Eurozone as the sharp rise in the Euro year to date has not penalized exports/growth so far. In fact, German unemployment fell to a record low in September. The European Commission released economic sentiment numbers last week, which include both businesses and individuals, and it rose to a 10-year high of 113.0. Interestingly the survey revealed that businesses expect higher prices and costs over the next year although clearly not apparent now. It will be difficult for the ECB to start reducing its stimulus unless inflation begins to show some signs of increasing coupled with the Euro falling.

It was not surprising that China reported surprisingly strong economic statistics just before the start of the National People’s Congress in two weeks. China’s factories grew at the fastest pace since 2012: the official PMI increased to 52.4 in September with input price index at 68.4 vs. 65.3 in August while the Caixin/Market PMI actually fell slightly to 51.0. China will officially begin reducing steel and aluminum capacity October 1st to reduce pollution and cut global oversupply responding to trade charges from the U.S. and Europe.

The WTO has confirmed that global trade has picked up meaningfully this year with volume expected to increase 3.6% versus 1.3% in 2016. Their former forecast for 2017 was 2.1% made back in April. All regions are expected to show growth, which has not been seen for many years and reveals the strength and breath of the global pick up. At the same time, the IMF is warning all monetary bodies that weak wage growth continues and is of great concern so be careful when/if reducing monetary stimulus. We continue to believe that all monetary bodies will stay one step behind as growth accelerates which is good for financial assets.

Clearly the tenor of the stock markets has recently improved somewhat as the bears/pundits have lost so much credibility having been wrong for so very long. They are still looking through the rear-view mirror rather than through the windshield and over the rainbow.

I have rarely seen an environment as conducive for profitable investing as now with non- inflationary growth accelerating; interest rates so low for this stage in an economic recovery – although the yield curve will steepen further; financial risk declining as bank capital and liquidity ratios continue to risk and corporate earnings taking off as volume is finally growing after years of stagnation with costs under tight control. It certainly does not hurt to finally have a pro-growth, pro-business administration in DC.

Let’s wrap this up: we continue to concentrate our portfolios on the strongest money center bank which will benefit from loan growth and a steepening yield curve; global multinational industrials benefiting from an acceleration in volume, margins, earnings and cash flow; technology at a fair price relative to growth; industrial commodity stocks benefiting from rising demand, declining inventories and higher margins/earnings and free cash flow including domestic steel and aluminum companies that will benefit from a substantial curtailment in Chinese capacity and dumping beginning Oct 1st; and special situations like DowDuPont, Huntsman, Praxair and FMC, a large lithium producer that goes into electric vehicles.